Why Are Credit Unions Tax Exempt? Do You Really Know?

Yes, credit unions pay millions of dollars in property, sales and employment taxes each year. But credit unions enjoy a federal exemption on corporate income taxes. Why is that? Do you really know? Or do you just think you know?

Note: The Financial Brand takes no position on whether credit unions should- or should not have federal tax exemptions. This article simply examines the underlying reasons and arguments for the tax exemption.

Requirements aren’t the same as reasons

The most common argument asserts that credit unions are tax-exempt because they are not-for-profit. Technically this is correct because taxes aren’t owed when there is no income. (Non- and not-for-profit organization’s must reinvest all their income in ways that exclusively benefit of the organization and/or its members.)

There is a significant difference between legal “requirements” and justifiable “reasons.” The reason credit unions are tax-exempt isn’t because they are not-for-profit. Actually, it’s the other way around. Congress requires all tax-exempt organizations be either non-profit or not-for-profit. Not-for-profit status is a requirement for federal tax-exemptions, not the reason behind it. It defines who gets the tax exemption, not why.

Can anyone create any kind of non- or not-for-profit business? No. Could you launch a non-profit porn shop? Obviously no. There are only special kinds of organizations that Congress deems worthy of tax exemptions and that’s because they provide some manner of valuable social service. In exchange for a tax exemption, they require these organizations to be non- or not-for-profit.

Other requirements commonly offered as reasons

Congress prohibits not-for-profit organizations from having private ownership. They can’t issue stock. And their boards of directors can’t personally benefit in any taxable way. In order to qualify for tax exemptions, an organization must conform to the structure of not-for-profits as defined by Congress. That’s why credit unions are member-owned and have volunteer boards.

Could someone start a member-owned chain of gas stations with an all-volunteer board and qualify for a tax exemption? No. It isn’t about member-ownership.

It’s not about “democratic principles” either. Credit unions often cite their democratic principles when justifying their tax-exempt status, but taxed corporations — with their shareholder votes — embrace the same ideals. Democracy is wonderful, but it makes no difference to an organization’s tax status.

Tax codes shed some clues

A review of IRS tax codes relevant to credit union taxation clearly reveals the legal criteria — who qualifies for a tax exemption — while giving us glimpses about the underlying rationale — the “why.”

Credit union scholars trace the origins of the industry’s tax exemption back to the First World War. Under Title VIII of the War Revenue Act of October 1917, Congress notes that “co-operative building and loan associations which are organized for the benefit of their members” (among other organizations) would not be subject to levies related to the cost of the war in Europe. But this arcane reference applies specifically to the levying of war stamp taxes and nothing more.

In 1934, Congress passed the Federal Credit Union Act, which in turn became Federal law 12 U.S.C. Chapter 14. The only section dealing with taxation, § 1768, says “Federal credit unions and their income shall be exempt from all taxation.” But this merely acknowledges that federal credit unions get a federal income tax exemption. No further explanation is provided.

The section of Federal law concerning not-for-profits, 26 U.S.C. 501(c)(14), states that credit unions must “operate without profit and for the mutual benefit of its members.” This is simply a restatement of the conditions organizations must meet in order to qualify for tax exemptions. Credit unions, just like every other not-for-profit organization, are required to return all gains back to its constituents. It’s a requirement imposed by Congress.

The next significant chunk of legislation can be found in the Revenue Act of 1951, where Congress revoked the tax-exempt status of building and loan associations, cooperative banks and mutual savings banks, while simultaneously adding specific language exempting credit unions. Authorities on banking tax codes believe these thrifts lost their tax exemption because they were actively competing with commercial banks for public savings and real estate loans. When Congress felt they were no longer providing a wider public service, they became taxed like for-profit commercial banks.

Nearly 30 years later in a 1979 report, the IRS theorized that “the reasons for removal of tax exempt status for mutual savings banks and savings and loan associations was their fundamental departure from the principles and purposes of their formation.”

In the report, the IRS explores the reasons Congress might have treated credit unions differently. “A major reason for the establishment of credit unions in this country was to provide their members with a source of personal loans, in small amounts and for a short term, which generally were difficult to obtain from other financial institutions,” the IRS noted.

But at the time, the IRS acknowledged fundamental differences between credit unions and other financial institutions, and thus treated them differently with respect to the application of tax laws. The most significant distinction noted by the IRS was the requirement for “a meaningful, written, and enforced common bond for its members, typically including: (1) employees of a particular business or institution, (2) members associated in a particular organization, or (3) residents of a well-defined neighborhood or community.” But these are more requirements, not reasons.

Social service justifies tax exemptions

Every nonprofit and not-for-profit organization in the U.S. fulfills some sort of civic or social role. These are often purely benevolent organizations, many of which are supported entirely by volunteers and/or donations. Look at the list of not-for-profit organizations and you’ll find religious, charitable, scientific, amateur and literary groups. There are civic leagues, social clubs and chambers of commerce. These not-for-profit organizations “do good stuff” in communities that other taxed organizations don’t or won’t — e.g., things like fighting to prevent cruelty to children and animals. That’s why Congress determined they were worthy of tax exemptions. When the U.S. government wants to provide a social service to the American people, Congress can either fund a governmental department or it can give private organizations tax breaks.

Looking back to 1934 when Congress passed the Federal Credit Union Act, you find that the purpose of credit unions was to make credit available to people of small means through a national system of cooperative credit, and to encourage thrift through cooperative saving.

In 1997, the chairman of CUNA affirmed this social directive in his testimony before the Committee On Banking & Financial Services. “[Credit unions] are the only financial institutions chartered with the social mission of making loans available to people of small means and teaching the benefits of thrift.”

When Richard Nixon signed Executive Order #11580 giving the NCUA its official seal in 1971, he expressly noted credit unions’ mission included the “cultivation of thrift, encouragement to save regularly, granting of loans for provident purposes at a reasonable interest rate, and budget and consumer counseling.”

As Andrew Reschovsky, a professor at the University of Wisconsin-Madison, summarizes, “The core issue [concerning taxation] is whether credit unions fulfill a public purpose, such as providing access to credit markets for families, individuals and businesses that commercial banks do not lend to.”

Conclusion

The reason behind credit unions tax exemption has everything to do with themes like “people of modest means,” “loans for provident purposes,” “teaching thrift” and “financial education.” By offering loans to those who might not otherwise have access to credit, Congress feels credit unions provide a public service that is as necessary as any other social program it might subsidize — something Americans need, not unlike the Centers for Disease Control or U.S. Department of Housing & Urban Development.

It’s smart for credit unions to talk about their structure — that they are not-for-profit, member-owned, democratic financial cooperatives — both for marketing and political reasons. From a branding perspective, it helps reassure credit union members and the general public that credit unions aren’t in it for the money; no one’s in it to get rich. It also helps credit unions justify and explain claims of “better rates, fewer fees and great service.” From a political perspective, it gives voters and their Congressional representatives warm fuzzies credit unions can use to insulate themselves from undesirable legislation. But the structure of credit unions is not why they have tax exemptions.

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Comments

The first part of that section you quote starts with: “The Federal credit unions organized hereunder”

As our organizational structure hasn’t changed since 1934, one has to assume that the structure was an integral part of the reason for the tax exemption as well as the other items that preceded this, culminated in a decision for tax exemption.

To assume that we were granted tax exemption on a whim is a bit of a big jump… but then, I wasn’t there.

I think the argument you make that the reason behind credit unions’ tax exemption is not their structure is chicken-and-egg. Credit unions would not be tax exempt if they were for-profit so their not-for-profit structure is at least part of the reason.

In the end the reason for credit unions tax-exempt status boils down to one thing: the government allows it. Credit unions then have to earn it everyday by contributing to the economic well-being of the citizenry and the country as a whole. Taking the exemption for granted is the greatest threat to losing it.

As the article points out, simply running a not-for-profit business isn’t sufficient to obtain a tax exemption. There’s more to it. Not just any organization can be not-for-profit and tax-exempt. Congress only allows certain types of organizations to be non- and not-for-profit. So why did Congress decide to include credit unions in its list of qualifying not-for-profits? Why would Congress grant tax exemptions to credit unions but not allow me to start a not-for-profit, tax-exempt chain of gas stations? What is their criteria? It’s about providing a service with social value that other for-profit businesses don’t/won’t provide.

As you correctly point out, the tax exemption does not arise from the structure of credit unions; but rather from the public purpose they fulfill. This may explain why the credit union tax exemption was scrutinized by various commissions this year. These commissions came to the conclusion that credit unions are not fulfilling a public purpose.

I also appreciate the links to the 1979 IRS study and to the Nixon executive order regarding the seal for the NCUA.

Remember that building and loan associations were not-for-profit and run by all-volunteer boards at the time they lost their tax exemption.

Tax exemptions are normally only extended to organizations providing a public service that other for-profit companies aren’t offering or won’t offer. If for-profit companies start offering the same public service(s) and/or the tax-exempt organization starts providing too many services that compete with for-profit companies, the tax exemption is usually withdrawn.

If credit unions are supposed to offer products that commercial banks do not why are credit unions lobbying so aggressively to get legislation passed to allow them to use 30% of their assets to lend to businesses and not to “people
of small means”. Also being not-for-profit does not necessarily mean no income. Many credit unions have more net income than banks. This net income builds up to a large amount of capital that is not taxed. Some credit unions then convert to a savings bank. Who gets that wealth that was not taxed. It is time to get away from the warm fuzzy feelings for credit unions and examine why they still are tax exempt and have them start to pay their fair share of taxes to help support our country and contribute to paying down the huge federal debt.

@Steve – Nowhere does it say or suggest credit unions are supposed to “offer products that commercial banks do not.” Indeed Congress intended the contrary. They sought to provide the same services banks offer, just with a focus on people of modest means. Congress didn’t spell out “what” they wanted credit unions to offer, just to “whom.”

You make some very interesting points here! I am a strong supporter of credit unions, but have always explained the tax exemption in terms of legislation, instead of in terms of values. Thanks for sharing this!

So editor, are you saying in your comment from 12-27-2010 at 9:27 “or the tax-exempt organization starts providing too many services that compete with for-profit companies, the tax exemption is usually withdrawn”.has not happened? Have you seen an ad from a Credit Union lately? They are specifically competing with commerical banks. If it looks like a duck, quacks like a duck, its a duck. Credit Unions are no longer fulfilling a need that can not be provided by for profit companies. Can you name any other industry that has two companies that are located side by side, offering essentially the same products and services where one is tax exempt and the other one isn’t? I am all for tax-exempt entities as long as they truely deserve the exemption. Credit Unions are no longer operating like they did in the 30’s, so why are we still allowing them tax exempt status.

The Financial Brand takes no position on whether credit unions should be taxed or not. That’s a political debate beyond the scope of this publication. The only purpose of this article is to clarify why credit unions have the tax exemption, not whether they deserve one or not. Credit union marketers often misrepresent and/or misunderstand the nature of the tax exemption (e.g., they say “we are not for profit because we are member owned” in their marketing).

I’m sure you can understand why a publication that caters to the interests of both bank and credit union marketing executives would not take a position on this issue. There is zero upside.

The Financial Brand has always been and will always remain agnostic on the “bank vs. credit union” debate.

1. Consider the fact that more than 200 credit unions have assets over $1 billion, making each of them larger than 90 percent of taxpaying banks. These large credit unions comprise only three percent of the entire credit union industry, but account for 62 percent of the tax exemption. These large, fast-growing, and increasingly complex credit unions have diversified to the point that they bear no resemblance to the traditional credit unions that Congress envisioned to be worthy of preferred tax status. At a minimum, these credit unions should have to pay income taxes like any other for-profit organization.

2. The typical credit union member has higher than average income, more years of education, and is more likely to own a home than non-credit union members. Credit unions serve a wealthier and more educated customer base than taxable banks, yet they are given a tax exemption that subsidizes financial services to those who clearly do not need it.

Considering a federal tax rate of 34% and a California state tax rate of 11%, a community bank competing with a credit union for a 5% loan would have to charge an interest rate of approximately 9% to get the same return for its shareholders as the credit union. Given the points made above, it is totally unfair in a free market system. I joined a credit union (Kinecta) and since I didn’t meet any of the “membership” requirements, I was told they would merely charge me a one time fee of $10 and I could open an account. Its a joke.

Thank you.
I would agree most of the small credit unions serve their original purpose but the ones who circumvate these principles should be taxed.

Thanks for the article. I appreciate its balanced look at the history of my industry. In my role as head of Internal Audit at a mid-sized credit union I have “professional skepticism”, an intimate knowledge of my credit union’s board and executive management decisions, and a strong familiarity with those of other credit unions. From that experience, I’d like to respond to Dave’s characterization of “hid(ing) funds; paying for expensive trips, vacation homes and leasing luxury cars for members of their boards and senior management”.

Like banks, Credit Unions are VERY highly regulated. I can assure your readers that neither I, nor our regulators, would ignore that sort of unethical and illegal behavior. In fact, it is in stark contrast to my experience at this credit union. Our Board members are ACTUALLY volunteering their time because in that role they are ACTUALLY controlling our strategy. As a result, our strategy is ACTUALLY focused on doing good things for our members and our community.

It’s worth emphasizing the specific tax from which we are exempt. It is very narrowly federal and state corporate income tax (we already pay all other forms of taxes). To what would that tax apply? We don’t make an excess profit with designs on giving it to shareholders. We only earn enough to maintain the “equity” required of us by regulation. By requiring that equity on the one hand, and taxing the income that supports it on the other, you cripple the opportunity for this sort of financial good.

I encourage your readers to consider carefully the good work done by my industry, and understand that our not-for-profit status is necessary to maintain the “equity” balance required by regulation and prudent management. Agree or disagree with that assessment as you wish, but I strongly encourage your readers to consider the question without entertaining the banking-lobby’s false characterization of credit unions unethically manipulating a loophole for personal gain. Not convinced? Join a credit union and attend a board meeting. They’re open to members because we don’t have anything to hide.